Back in January, when the Fed released its Fourth Quarter “Senior Loan Officer Opinion Survey on Bank Lending Practices”, it revealed something ominous: in Q4, lending standards across the US banking sector tightened for the second consecutive quarter. This was a problem because as Deutsche Bank pointed out at the time, two consecutive quarters of tightening Commercial & Industrial loan standards “has never happened before without it signalling an eventual move into recession and a notable default cycle. Once we have 2 such quarters lending standards don’t net loosen again until the start of the next cycle.”
Then, three months ago, we got confirmation of three consecutive quarters of tightening lending standards when senior bank loan officers reported the tightest lending standards on net since the financial crisis. Needless to say, if a recession and a default cycle have always followed two quarters of tighter lending conditions, three quarters does not make it better.
Fast forward to today, when the Fed’s latest Senior Loan Officer Survey for July 2016 showed that banks continued to tighten standards on commercial loans in 2016 for both commercial and industrial (C&I) and commercial real estate (CRE). This was the fourth straight quarter of tighter standards, and – again – something that has never happened outside of a recession.
Banks received the survey on or after June 28 and responses were due by July 12.
In discussing the standards and terms of C&I loans, the report said, “changes to terms on C&I loans for large and middle-market firms were mixed. Specifically, a modest percentage of banks reportedly narrowed spreads of loan rates over the cost of funds, while moderate fractions of banks reportedly increased the premiums charged on riskier loans, on net. Banks also reported that changes in the terms of loans to small firms were mixed: Whereas moderate shares of banks reported having narrowed spreads of loan rates over the cost of funds and having decreased the use of interest rate floors, on net, modest percentages of banks reportedly increased the premiums charged on riskier loans and tightened loan covenants on net.”
We can only assume loans with tightened loan covenants were mostly those issued to US energy companies; and with oil prices suddenly tumbling again, we see no reason why standards will ease any time soon; on the contrary the tightening trend is likely to continue.
Demand for C&I loans was about unchanged from the prior report, while that for CRE loans “had strengthened in the second quarter on net.” The report said, “Regarding the demand for C&I loans, domestic banks reported that demand from large and middle-market firms and from small firms was little changed, on balance, during the second quarter. Most banks that reported stronger loan demand cited the following as important reasons: increases in customer inventory financing needs, customer accounts receivable financing needs, and customer investment in plant or equipment. Conversely, half or more of the banks that reported weaker loan demand cited as important reasons decreases in these same three categories.”
While corporate loan demand was tepid (perhaps in response to anticipating more stringent lending standards), the opposite was true for households. Here demand was stronger “across all consumer loan types.” Demand for “most categories of RRE home-purchase loans” was stronger over the second quarter. The report said, “Significant net fractions of banks reported stronger demand for GSE-eligible, government, QM non-jumbo non-GSE-eligible, QM jumbo residential, and non-QM jumbo residential mortgages, and a moderate net fraction of banks reported stronger demand for non-QM non-jumbo residential mortgages. Credit standards were reportedly little changed for approving applications for revolving home equity lines of credit (HELOCs), and a significant fraction of banks reported that demand for revolving HELOCs had strengthened on net.” Overall, it would appear that consumers were motivated by declines in mortgage interest rates and the prospect of higher rates in the future.
Furthermore, responses indicated that standards for C&I loans “remained at levels that are easier than or near the midpoints of their ranges since 2005, except for syndicated loans to below-investment-grade firms, for which a moderate net fraction of banks reported that standards are currently tighter than the respective midpoints.” For CRE loans, “domestic banks reported that the current levels of standards on all major categories of these loans are tighter than the midpoints of the ranges that have prevailed since 2005.”
For RRE loans, “domestic banks reported that lending standards for all five categories included in this survey question (GSE-eligible mortgages, government-insured mortgages, jumbo mortgages, subprime mortgages, and HELOCs) remained tighter than the midpoints of the ranges observed since 2005. Of note, a major net fraction of banks reported that the current level of standards on subprime residential mortgage loans is tighter than the reference point.” Lending standards for potential homebuyers could still be a barrier for those on the margins.
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Putting this result in context, this is what BofA’s Michael Contopoulos said 3 months ago:
The two best predictors of the US default rate are C&I lending and the proportion of downgrades to upgrades within high yield. With both deteriorating over the last several quarters our model now suggests a default rate over the next 12 months of 5.4%. We note, however, that the model this time last year forecast a 2.7% default rate yet with the high degree of Energy defaults, we have actually realized a 5.3% rate as of April 30th. It stands to reason, then, that our model, usually highly accurate in its calculation, could be understating the actual default rate over the next 12 months. We think there is upside to our forecast of 5-6% this year, and caution investors that non-commodity defaults are also likely to rise absent a complete opening of capital markets.
As of today, the default rates are far higher: earlier today, Moody’s reported that the overall US speculative-grade default rate rose to 5.1% from 4.4% in the second quarter and is projected to jump to 6.4% – its highest level since June 2010, Moody’s reported. Moody’s added that the US speculative commodity default rate rose to 23.9% in the second quarter from an already high 19.9% in the prior quarter.
“A growing US economy and the ongoing benefits of receptive capital markets over the last few years has constrained much of the stress to the commodities sector,” the rating agency said.
Also contrary to popular opinion, it’s not just energy companies. “While sector default risk remains heavily concentrated in commodity companies, the default rate and credit strains outside of commodities are edging up, but remain far less pronounced,” Moody’s said.
But what is more troubling is that as the default rate was picking up, so were oil prices, which at least in theory was supposed to alleviate the biggest catalyst for the spike in defaults – a cash crunch. That is no longer the case, and as we approach the midpoint of Q3, oil prices are again tumbling in a replica of last year, with many wondering not only if there will be a rerun of the energy sector collapse witnessed in late 2015, but if it will once again spread to domestic banks.
Then again, we know that banks have surely taken appropriate measures and charged off substantial amounts to factor in for another potential slowdown in the energy sector. After all, even the Dallas Far is no longer “advising” banks to quietly Mismark to nonmarket their loan books, unlike what it did a year ago.
We also know that for the first time in history, the ECB is directly buying corporate bonds, a move which has since resulted in an unprecedented scramble to frontrun those bonds which Mario Draghi will monetize, in the process decoupling corporate bonds, and to an extend loans all the way in the shale sector, from underlying fundamentals.
So putting these two observations together, there is likely nothing to worry about and for the first time in history, 4 straight quarters of tightening lending standards will not be the traditional recessionary indicator they have always been. Unless, of course, this time happens to not be different after all.
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